Low-Cost Funds Outperform High-Cost Options

Many mutual fund investors believe that minimizing expense ratios and other fees is the key to success.

It’s easy to understand, theoretically. Just imagine two identical funds that earned nothing over 20 years. One charging fees of 1% a year would lose roughly 20% of its value, while the other, charging only 0.2%, would lose roughly 4%. (We say “roughly” because losses cost less as the investment decreases.)

Fees can have the same corrosive effect on funds with positive returns. But you don’t have to rely on theory or faith, as there are real-world facts to support the low-fee belief system. The latest comes from a new study by Morningstar Inc. (Stock Quote: MORN), the market-data firm.

“If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better [investment] decision,” writes Morningstar Research Director Russel Kinnel. “In every single time period and data point tested, low-cost funds beat high-cost funds.”

The study looked at various measures, including average annual returns over the period studied, from the beginning of 2005 through March 2010. The survey compared returns of the 20% of funds with the lowest expenses with the 20% with the highest expenses — the cheap and expensive “quintiles.”

Among U.S. stock funds around since 2005, the cheap funds returned 3.35% a year, while pricier ones yielded 2.02%. Similar margins were found in funds investing in international equity, a stock-and bond mix (balanced funds), taxable bonds and municipal bonds.

The low-fee funds also beat high-fee funds for all shorter periods, starting in 2006 through 2008.

Morningstar also figured “success ratios,” or the percentage of funds that survived the entire period while beating average returns in their respective categories. This view adjusts for the fact that poor-performing funds are often shut down or merged into other funds, distorting the statistics. Again, low-cost funds did better.

"The gap was also impressive as measured by the success ratio because high-cost funds are much more likely to have poor performance and be liquidated or merged away,” Kinnel said. “For the 2005 group, we found that 48% of domestic-equity funds in the cheapest quintile survived and outperformed versus 24% in the priciest quintile. Put another way, funds in the cheapest quintile of domestic equity were twice as likely to succeed as those in the priciest quintile."

Cheaper funds had better success ratios in the other categories and time periods, as well.

Finally, Morningstar looked at its own star-rating system, which measures each fund’s performance in relation to expenses and risk, or how wildly it swings in value. Many investors favor funds with top five-star ratings to those with fewer stars.

Generally, the five-star rated funds beat those with just one star, especially when results were adjusted to reflect the funds that had been shut down or merged with others. In data from 2005, for example, 53% of the five-star funds survived and beat their category average, compared to just 13% of one-star funds.

"Investors should make expense ratios a primary test in fund selection," Kinnel concludes. "They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you’ll be on the path to success."